A-17. Compute Net Present Value Dungan Corporation is evaluating a proposal to p
ID: 2745011 • Letter: A
Question
A-17. Compute Net Present Value
Dungan Corporation is evaluating a proposal to purchase a new drill press to replace a less efficient machine presently in use. The cost of the new equipment at time 0, including delivery and installation, is $200,000. If it is purchased, Dungan will incur costs of $5,000 to remove the present equipment and revamp its facilities. This $5,000 is tax deductible at time 0.
Depreciation for tax purposes will be allowed as follows: year 1, $40,000; year 2, $70,000; and in each of years 3 through 5, $30,000 per year. The existing equipment has a book and tax value of $100,000 and a remaining useful life of 10 years. However, the existing equipment can be sold for only $40,000 and is being depreciated for book and tax purposes using the straight-line method over its actual life.
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Management has provided you with the following comparative manufacturing cost data:
The existing equipment is expected to have a salvage value equal to its removal costs at the end of 10 years. The new equipment is expected to have a salvage value of $60,000 at the end of 10 years, which will be taxable, and no removal costs. No changes in working capital are required with the purchase of the new equipment. The sales force does not expect any changes in the volume of sales over the next 10 years. The company's cost of capital is 16 percent, and its tax rate is 40 percent.
Required
Calculate the removal costs of the existing equipment net of tax effects.
Compute the depreciation tax shield.
Compute the forgone tax benefits of the old equipment.
Calculate the cash inflow, net of taxes, from the sale of the new equipment in year 10.
Calculate the tax benefit arising from the loss on the old equipment.
Compute the annual differential cash flows arising from the investment in years 1 through 10.
Compute the net present value of the project.
Explanation / Answer
Answer 1 the removable cost of existing manchinery is 5000 Tax rate 40 Removal cost tax sheild will be = 5000*40% 2000 Post tax removal cost of the existing manchinery = 5000*(1-.40)= 3000 Answer 2 Calculation of depriciation Tax Sheild New Manchinery Year Depriciation Tax rate Depriciation Tax sheild A B A*B 1 14000 40% 5600 2 14000 40% 5600 3 14000 40% 5600 4 14000 40% 5600 5 14000 40% 5600 Present value 200000 Salvage value 60000 Straight line depriciation =( 200000-60000) / 10 14000 Calculation of depriciation Tax Sheild old Manchinery Year Depriciation Tax rate Depriciation Tax sheild A B A*B 1 10000 40% 4000 2 10000 40% 4000 3 10000 40% 4000 4 10000 40% 4000 5 10000 40% 4000 Present value 100000 Salvage value 0 Straight line depriciation =( 100000-0) / 10 10000 As per question the depriciation will be allowed only for 5 years So, depriciation tax sheild will be restrited to only 5 years only Answer 3 Calculation of forgone Tax benefit of old manchinery can be 1) Excess of expenses incurred in old manchinery old New Difference Tax rate% Tax sheild Lobour 30000 25000 5000 40% 2000 others 48000 20000 28000 40% 11200 Depriciation 10000 14000 -4000 40% -1600 Forgone Tax benefit of old manchinery 11600 Answer 4 Calculation of cash flow - net of tax from sell of new manchinery in year 10 Salvage value 60000 Tax rate 40% Tax to be Paid on it =60000*40%= 24000 Inflow net of Tax = 60000-24000= 36000 Answer 5 Calculation of Tax benefit arising on sale of old manchinery present value 100000 Sale value 40000 Loss = 100000-40000= 60000 Tax rate 40% Tax benefit=60000*40% 24000 Answer 6 Calculation of annual Differencial cash flow from Investment will be calculated in Two parts first will be 1 to 5 years and second will be 6 to 10 years due to non availbility of depriciation tax sheild after 5 yrs Differencial cash flow from year 1 to year 5 saving in labor cost = 30000-25000= 5000 saving in other cost = 48000-20000 = 28000 excess depriciation tax sheild = 5600-4000= 1600 Annual differencial cash flow from 1 to 5 yr 34600 Differencial cash flow from year 6 to year 10 saving in labor cost = 30000-25000= 5000 saving in other cost = 48000-20000 = 28000 Annual differencial cash flow from 6 to 10 yr 33000 Answer 7 Calculation of the Net present value of the project Initial Investment 200000 Actual removal cost 3000 Sale of old manchinery 40000 Loss on sale tax benefit 24000 Actual outflow will be = 200000+3000-40000-24000= 139000 calculation of present value of Inflow from investment Year Differencial cash flow PV @ 16% 1 34600 29827.59 2 34600 25713.44 3 34600 22166.76 4 34600 19109.27 5 34600 16473.51 6 33000 13544.59 7 33000 11676.37 8 33000 10065.84 9 33000 8677.45 10 33000 7480.56 Total 164735.38 Year Salvage value of new Tax paid Inflow Pv @ 16% 10 60000 24000 36000 8160.61 present value of total Inflow = 164735.38+8160.61= 172895.99 or 172896 Net present value of the project = Inflow - outflow = 172896 - 139000 = 33896 (positive)